Rite Aid (NYSE: RAD ) has been full of surprises since 2013, and therefore its stock has soared 500%. However, its first quarter lacked any such surprises. So in looking ahead, is Rite Aid still a stock that can outperform peers CVS Caremark and Walgreen (NASDAQ: WBA ) ?
A history of surprises
On Dec. 20, 2012 Rite Aid reported its first quarter of net income in half a decade, which thereby initiated what has become a tremendous 16 months of stock gains. The profit served as a pleasant surprise for a company that many thought was destined for bankruptcy, and it was then followed by seven consecutive quarters of net income.
Rite Aid's improvement in margins has been a result of increased generic-drug introductions. These drugs are cheaper to purchase, allow for larger markups, and are often bought in bulk, thus creating savings on logistical costs. Therefore, this process continued to drive margins even higher, which thereby led to higher guidance from the company, another pleasant surprise.
This domino effect took another step forward as new-found profits gave Rite Aid the capital to continue its store-remodeling program, which then drove traffic higher. As a result, Rite Aid has returned to growth, yet another surprise.
Rite Aid now projects that this growth will be ongoing as its new initiatives have had a positive effect. Most notably Rite Aid has increased the use of technology by using devices like iPads to become more useful to consumes. Its Health Alliance program for the elderly and ill has made it easier for physicians, pharmacists, and insurance companies to work as one, making Rite Aid a top destination spot for this population. Lastly, its new distribution partnership has cut inventories and has Rite Aid better positioned for an industry with higher generic volume.
So what's wrong?
The problem for Rite Aid is that after a 500% gain since 2013, the stock has priced increased margins and revenue growth into the valuation of the company. Rite Aid released a very strong first quarter, with $41.4 million in net income, total revenue growth of 2.7%, and a 4.3% boost in its pharmacy same-store sales. Unfortunately, these things were expected, and shares fell more than 3% on the news. It seems that stock gains may become more difficult as increased optimism is priced in.
What's next for these competitors?
In looking ahead, Rite Aid is no longer full of surprises and will thereby trade according to its fundamental improvements. While it remains significantly discounted to peers CVS and Walgreen on a price-to-sales basis, Rite Aid is not growing nearly as fast nor is it as profitable. Therefore, accelerated revenue growth beyond the expected 2% could lead to larger returns, but anything equal likely means a flat-performing stock.
If Walgreen buys Alliance Boots, it'll get Boots' $36 billion in annual revenue, $1.3 billion in profit, and a new market in the United Kingdom. Additionally, Walgreen would gain the UK's corporate tax rate of 21% versus 35% in the U.S., saving the company hundreds of millions a year in tax-related expenses.
Not to mention, Walgreen creates the majority of its revenue from prescriptions while Alliance operates mainly as a pharmacy wholesaler. Therefore by combining, Walgreen and Alliance inventories can be utilized more efficiently and distribution channels can be perfected, and Walgreen can make an attempt at becoming a worldwide company, which is clearly a larger market.
Rite Aid and CVS might very well trade higher long term, but if so it will be due to fundamental improvements that exceed Wall Street's expectations. With that said, Walgreen has since become the exciting company within this space, and given the benefits of an Alliance Boots acquisition, I think investors should feel pretty good about the long-term direction of the stock.
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